Ian Cowie was named Consumer Affairs Journalist of the Year in the
London Press Club Awards 2012. He has been head of personal finance at
Telegraph Media Group since 2008, having been personal finance editor
since 1989. He joined the paper in 1986. He is @iancowie on Twitter.

Pensions: some good news at last

New freedom of choice about how you spend your pension means retirement really could be the holiday of a lifetime – if you save hard enough

Despite all the doom and gloom about pensions, you can find some good news if you look hard enough. Yes, really. For example, did you know that defined contribution (DC) or money purchase pensions can be better than defined benefit (DB) or final salary schemes?

That’s why I began banging on about ‘pensions apartheid’ more than a decade ago. Here and now, there is not much point in howling at the moon. So, on the basis that it is better to laugh than cry, let’s consider one way in which DC savings – which include all personal pensions and most company schemes – are better than the safe and steady plans they replace.
Their inherent uncertainty – being based on stock market valuations – also means they are more flexible than traditional pensions. If that sounds theoretical, consider the position of people who – willingly or unwillingly – retire early.

Those who are members of traditional DB schemes are punished for doing so by means of what is euphemistically described as an ‘actuarial reduction’. The logic is impeccable because the younger the person is at retirement, the longer they are likely to receive their pension. But this early exit penalty can still seem pretty harsh if illness or redundancy forced your retirement.

For example, senior actuary Ron Amy, former chief executive of Aon Consultants, told me: “The reduction will usually be 4pc for each year you go early – and some scheme’s actuaries could deduct more. So there would be a 40pc reduction in pension for a man who retires at 55 instead of 65 and there would be a similar reduction in the yield you could obtain from an annuity.”

Regular readers will know that one of the few things the Coalition Government has done to help savers is to scrap the legal compulsion to spend at least three quarters of your pension savings on an annuity or guaranteed income for life. It’s not the sort of thing that will make TV or tabloid headlines but it is a valuable extension of individual choice which rising numbers of people reaching retirement with DC pensions will benefit from.

Here’s why. The shares don’t care how old you are. The yield is the yield is the yield; whether you are 55 or 65. So people who have saved sufficiently to cope with fluctuating valuations can leave their pensions invested in shares, bonds or stock market-based funds and live off the income they produce.

That option was not available to earlier generations. True, they enjoyed the certainty of receiving a sixtieth or eightieth of final salary for each year’s service; a degree of security most people would still rather have today. But the golden age of pensions is gone and it is not coming back.

So we may as well make the most of the new rules and the first step is to save sufficiently to retire with a big enough fund to afford the new flexibility. For example, Billy Burrows of the Better Retirement Group reckons that you need to have saved at least £100,000 by the time you retire before considering foregoing the certainty annuities provide in favour of remaining invested and opting for what is known as income drawdown.

If that sounds like a lot, then remember that £100,000 delivers annual income of just £6,100 from the best annuity available today – and that is a fixed rate, before tax with the immediate loss of all your capital, because it is irrevocably transferred to the life company providing your guaranteed income for life.

By contrast, the maximum income drawdown allowed by the Government Actuary’s Department (GAD) for a man of the same age investing £100,000 is £5,300 net of basic rate tax. While there is no guarantee that capital and income may not fall in future, there is also the possibility they may rise – and the certainty that you retain ownership and control of your capital. The relevant yields for women are £5,800 gross from an annuity or £4,900 net from income drawdown. Both are lower than men’s because insurers and the GAD expect women to live longer than men, although the European Court will force equalisation of these rates from December.

No wonder new research by Friends Life has found rising interest in income drawdown as an alternative to annuity rates stuck at historic lows. While nine in 10 people currently retiring opt for the certainty an annuity provides, there was a marginal majority – just over 14pc compared to just under 14pc – among 2,000 adults questioned who intend to opt for income drawdown instead of annuities.

David Still of Friends Life commented: “With annuities becoming more expensive over the last couple of years, people are looking to alternatives. Income drawdown is typically more attractive to those with larger pension pots as they can accept the higher level of investment risk. In practice, we find that the certainty of the guaranteed income for life that is provided by an annuity is an important factor for many people.”

Similarly, Tom McPhail of Hargreaves Lansdown said: “It is understandable that investors are looking for alternatives, given the recent catastrophic falls in annuity rates. Many investors have been expecting or at least hoping for a higher level of income and so are reluctant to lock in at these current low levels.

“Investors should also be mindful that drawing maximum income from a drawdown plan is almost certainly unsustainable; long term investors should look at the kind of income levels payable from an inflation-linked annuity if they want a sustainable income which will rise over time. One option is to draw the natural yield from their investments so for a basket of equities this might mean around 4pc at present.”

That underlines just how much capital needs to be saved to generate a decent income in retirement for those born too late to enjoy the ‘golden age of pensions’. But the bad news is rather old news now and there is not much any of us can do about it. By contrast, if people knew the good news about increased choice at retirement, they might save more to make the most of it.